Introduction

y In July 1989, the International Accounting Standard Board (IASB) (then IASC) produced and published a document, called framework for the preparation and presentation of financial statements. y The Framework is, in fact, the conceptual framework upon which all IAS¶s are based and hence which determines how financial statements are prepared and the information they contain. y This Framework sets out the concepts that underlie the preparation and presentation of financial statements for external users.

Purpose 
Assist the Board in the development and review of future

International Accounting Standards. 
Assist the Board in promoting harmonization of regulations, accounting standards and procedures relating to the presentation of financial statements.  Assist national standard-setting bodies.  Assist preparers of financial statements in applying International Accounting Standards.  Assist auditors in forming an opinion.  Assist users of financial statements in interpreting the information.  Provide those who are interested in the work of IASB with information about its approach to the formulation of International Accounting Standards.

Scope 
The Objective of Financial Statements.  Underlying Assumptions.  Qualitative Characteristics of Financial Statements.  The Elements of Financial Statements.  Recognition of the Elements of Financial

Statements.  Measurement of the Elements of Financial Statements.  Concepts of Capital and Capital Maintenance.

The Objective of Financial Statements
y Financial Position
Financial position (balance sheet) shows the economic resources (assets) controlled by the enterprise, the financial structure (capital structure) and the liquidity and solvency (short and long term commitments and receivables).

y Financial Performance
Financial performance (profit and loss) shows the information particularly profitability. (Primarily ± Income Statement).

y Changes in Financial Position
Changes in financial position (cash flow) is used to assess the entity¶s investing (non-current assets) , financing (equity and long term liabilities) and operating activities.

Financial statements will meet the needs of most users; however the information is restricted: 
It is based on past events not expected future events.  It does not necessarily contain non-financial information.

In addition, It is important for users to assess the ability of an entity to produce cash and cash equivalents to pay employees, lenders etc.

Underlying Assumptions
y Accruals basis  Transactions and events are recognized when they occur (and not at the time of receipt or payment).  Recorded and reported in the financial statements of the periods to which they relate.  Show users past transactions involving cash and also obligations to pay cash in the future and resources which represent cash to be received in the future. Example: Under the accrual basis, revenues are recognized when both of the following conditions are met: a. Revenue is earned.(when products are delivered or services are provided). b. Revenue is realized (cash is received) or realizable (reasonable to expect that cash will be received in the future).

y Going concern  The concept implies that the business will continue to operate for the foreseeable future.  It is assumed that the entity has neither the intention nor the need to liquidate or curtail its operations.  The effect of going concern assumption is that assets and liabilities of the business are meant to be held for till their maturity (or useful life to the business) and are therefore measured and reported at their cost.  If the business is not considered to be a going concern then the assets and liabilities would have to be shown at their current market value. Example: if you recently purchased equipment costing $5,000 that had 5 years of productive/useful life, then under the going concern assumption, the accountant would only write off one year's value $1,000 (1/5th) this year, leaving $4,000 to be treated as a fixed asset with future economic value for the business.

Qualitative Characteristics

Qualitative Characteristics
y Understandability: 
Users must be able to understand financial statements.  They are assumed to have some business, economic and

accounting knowledge and to be able to apply themselves to study the information properly. 
Complex matters should not be left out of financial statements

simply due to its difficulty if its difficulty is relevant information.

y Relevance: 
The information is relevant if it effects the decision making of the

users (same information could be relevant to one report but irrelevant to another) . 
The manner of showing information will enhance the ability to

make predictions, e.g. by highlighting unusual items.

y Reliability: 
Information has a quality of reliability when it is free from

material error and bias. 
The user must be able to depend on it being a faithful

representation. 
Even if information is relevant, if it is very unreliable it may be

misleading to recognize it, e.g. a dispute claim for damages in a legal action. y Timeliness:  A balance between timeliness and the provision of reliable information must be maintained.  Information may become irrelevant if there is a delay in reporting it.  Information may be reported on a timely basis when not all aspects of the transaction are known, thus compromising reliability.

y Faithful representation: 
Information must represent faithfully the transactions it purports to represent in

order to be reliable. 
Means that the numbers and descriptions match what really existed or

happened. 
This fundamental characteristic seeks to maximize the underlying

characteristics of completeness, neutrality and freedom from error. 
Example: General Motors income statement report sales of $225 Billions when

it had a sales of $193.5, then the statement fails to faithfully represent the proper amount.
y Substance over form: 
Critical for reliable financial reporting.  It is particularly relevant in case of revenue recognition, sale and purchase

agreements, etc. 
Example: If two companies trade their inventories they will not be allowed to

record sales because not sales has occurred even if they have entered into valid enforceable contracts.

y Neutrality: 
Accounting standards provide the best possible information for economic

decision making without regard to how that information may affect economic, political, or social behavior. 
Neutrality is lost if financial statements are prepared so as to influence the

user to make a Judgment or decision in order to achieve a predetermined outcome. 
Example: financial information should be neutral and is not intended to favor

an investor over a creditor.
y Prudence: 
Where there are alternative methods or valuations, you should apply the one

with the most conservative result. 
Prudence does not allow the creation of hidden reserves or excessive

provisions, understatement of assets or income or overstatement of liabilities or expenses. 
Example: In deciding the value of stock, it would be prudent to use the cost

price of the stock as opposed to the selling price. This is because the sale of that stock is merely anticipated. The derived principle from this is that where revenue is anticipated, the valuation should be conservative or cautious.

y Completeness: 
Financial information must be complete within the restrictions of

materiality and cost, to be reliable. Omission may cause information to be misleading.  Example: if an accountant fails to record a valid expense transaction or liability account, the accounts will be understated. y Comparability:  The user must be able to compare an entity¶s financial statements:  Through time to identify trends and  With other entities¶ statements, to evaluate their relative financial position, performance and changes in financial position.  The disclosure of accounting policies is particularly important here..  Example: Historically the accounting for pension in US differs from that in Japan. US companies record pension cost as incurred, in Japan a little or no charge. As a result is difficult compare financial results of Ford to Japanese competitors.

Constraints on Relevant and Reliable Information
y Balance between cost and benefit: 
This is a pervasive constraint, not a qualitative characteristic.  When information is provided, its benefits must exceed the costs of

obtaining and presenting it. Cost<Benefits  It is therefore difficult to apply a cost-benefit analysis, but preparers and users should be aware of the constraint. y Materiality:  Information is material if its omission or misstatement could influence the decision of the user.  Materiality is not a primary qualitative characteristics itself (like reliability or relevance), because it is only a starting point or cut-off point.  Determining what is a material or significant amount can require professional judgment. For example, $5,000 might be immaterial for a large, profitable corporation, but it will be material or significant for a small company that has very little profit.

Balance et een q alitati e characteri tics 
A tradeoff between qualitative characteristics is often

necessary,  The goal is to achieve an appropriate balance to meet the objective of financial statements.  It is a matter for professional judgment as to the relative importance of these characteristics in each case.

Elements of Financial Statements
y The elements directly related to financial position

(balance sheet) are: 
Assets  Liabilities  Equity

y The elements directly related to performance

(income statement) are: 
Income  Expenses

y The cash flow statement reflects both income

statement elements and some changes in balance sheet elements.

IASB Definitions
y Asset: Resource controlled by the entity as a result of past events and y

y y

y

from which future economic benefits are expected to flow to the entity. Liability: Present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Equity: Residual interest in the assets of the entity after deducting all its liabilities. Definitions of the elements relating to performance Income: Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. Expense: Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

Recognition of the elements of financial statements
y Must satisfies the following criteria:  It is probable that any future economic benefit associated with the item will flow to or from the entity; and  The item has a cost or value that can be measured with reliability. y Based on these general criteria: y An asset is recognized in the balance sheet when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably. y A liability is recognized in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably. y Income is recognized in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. y Expenses are recognized in the income statement when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably.

Measurement of Elements of Financial statements
y Historical cost: Consideration paid (payable) or received (receivable)

at the time of recording of transaction (no relation to current costs). y Current cost: The consideration that would have to be paid if a same or an equivalent asset is acquired. y Realizable (Settlement) value: The consideration that would be realized by selling an asset in an orderly disposal. y Present value: A current estimate of the present discounted value of the future net cash flows in the normal course of business. **Historical Cost is the most commonly adopted measurement basis, but this is usually combined with other bases, e.g. inventory is carried at the lower of cost and net realizable value. ** Fair Value, Future Value and other measurements are also recognized by the framework.

Concept of Capital and Capital Maintenance
y Most entities use a financial concept of capital when preparing their financial statements. y Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the enterprise. y Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the enterprise based on, for example, units of output per day.

There are two concepts of capital maintenance:
y Financial Capital Maintenance
y A profit is earned only if the financial (or money) amount of the net assets

at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. y Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power. y Physical Capital Maintenance y A profit is earned only if the physical productive capacity (or operating capability) of the enterprise (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. ** The principal difference between the two concepts of capital maintenance is the treatment of the effects of changes in the prices of assets and liabilities of the enterprise.

Conceptual Framework IASB

Objective of Financial Statements

Underlying Assumptions

Qualitative Characteristics

Elements of Financial Statements

Recognition of the Elements

Measurement of the Financial Statements

Concepts of Capital and Capital Maintenance

Financial Position

Accrual Basis

Understandability

Assets

Balance Sheet
Income Statement

Historical Cost

Capital

Financial Performance
Changes in Financial Positions

Going Concern

Relevance

Liabilities

Current Cost

Financial Capital

Reliability

Equity

Realizable Cost

Physical Capital

Neutrality

Income

Present Cost

Timeliness

Expenses

Comparability

Conclusions
y A conceptual framework is like a constitution: The

framework is a coherent system of concepts that flow from an objective. The objective of financial reporting is the foundation of the framework . y Why do we need a conceptual framework?
y We can relate and establish body of concepts and

objectives in financial reporting. y Increase understanding and confidence for financial statement users. y Enhance comparability among companies. y Help us to solve new and emerging practical problems by referring basic theory.

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